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Tuesday, December 27, 2011

The subject of Dutch disease has been central to the debate of Brazilian macroeconomists and policymakers at least since commodities prices started to rise during the last decade. I believe that much of this debate is misguided, as it ignores some macro-financial interactions of great importance.

My thesis is that how the booming sector accumulates wealth is crucial to understand the consequences to the rest of the economy.

Let’s say there is a booming sector whose present income is above its permanent income (say, soy producers) and which is attempting to transfer purchasing power from the present to the future (i.e. to save).

For the sake of illustration, let’s assume that the only form of accumulating wealth was the purchase of an asset in fixed supply, such as land. Then the attempt of transferring purchasing power from the present to the future would bid up land prices and landowners would capture much of the increase in national wealth. In other words, we get a housing/land prices boom.

Now let’s introduce financial intermediaries. The booming sector now can save by purchasing assets issued by financial intermediaries who will lend the booming sector resources to sectors of the economy willing to dissave to expand their consumption or investment. In other words, the attempt to save by the booming sector fuels a credit (financial intermediation) boom.

Then notice that my argument does not mention at any point that the increased income in the booming sector is related to exports. The effort by the booming sector to save is the mechanism that causes the increase in financial intermediation or the spike in land and housing prices.

But increases in financial intermediation are also often associated with deterioration in credit quality, excessive leveraging and enhanced risk of a financial crisis. For those of us who are more inequality averse, rising land prices are a negative as the poor tend to be land-poor. It is up to policymakers to avoid the housing bubble and credit boom. It is obvious that goods and services in Brazil are excessively expensive, and for many observers, that is both cause and symptom of the loss in competitiveness that afflicts some sectors of the Brazilian economy (more noticeably, the most labor intensive sectors of manufacturing).

My point is that the key for the solution to this problem is to isolate the domestic economy from the consequences of the attempt to save by the booming sector and this can be accomplished by allowing the booming sector access to external assets, i.e., by letting the windfall leak out.

How then can policymakers make the windfall more likely to leak out? This can be done through a multi-pronged strategy.

First and foremost for the case of Brazil, access to external assets should be democratized, i.e. let soy farmers buy Apple stock on an online broker, this simple.

Second, regulations governing pension funds and institutional investors ought to lose their bias towards domestic assets. That would require a major reform and disturb powerful vested interests, but the benefits of such reform would go much farther than just macroeconomic management.

Third, let imports in! That sounds contradictory, but the more cars we import for China (and we import very little), the smaller will be the tendency of Real appreciation, and the more competitive will be our import competing industries.

But has this ever been tried? Yes, it has been tried and successfully. Chile has faced rising copper prices for the last decade, yet our finance- and trade-liberated cousins have avoided real appreciation. And just in case someone asks, they have also grown faster too.